U.S. SEC Tough on Asian Disclosure, Accounting Abuses as Investment Professionals Demand Progress
Unfortunately the news of bogus financial reporting appears to be never-ending. It is still a big concern in China — so big that even U.S. regulators are getting involved. Recently investors were again reminded about the potential challenges posed in the case of companies that are listed in foreign countries, be it through reverse mergers or IPOs. Readers of our blog are certainly aware of the Hontex case, just one example of how corporate governance and regulatory enforcement concerns have caught the attention of regulators and the public.
At the end of February 2013, the news broke that the U.S. Securities and Exchange Commission (SEC) had charged a China-based petrochemical company and its former CFO with accounting and disclosure violations, with the company and CFO agreeing to pay more than US$1 million combined to settle the charges.
The company in question, Keyuan Petrochemicals, manufactures and sells petrochemical products in China. Formed through a reverse merger, Keyuan Petrochemicals filed the securities registration statement back in May 2010 and listed on NASDAQ in the same year. Not long after, in 2011, there were already hints of dubious disclosure practices as it was made public that the company had received a notice from NASDAQ stating that it was not in compliance with the listing rules and had not filed its Form 10-K for 2010 by the due date. After submitting a plan of compliance to NASDAQ to maintain the listing, Keyuan Petrochemicals decided to move to the over-the-counter (OTC) market where its stock has been trading around US$1.
These days Keyuan Petrochemicals’ new U.S. investor relations officer, appointed just last October, must be very busy when communicating to shareholders, as there is much need for explanation. The SEC in a recent complaint alleged that between May 2010 and January 2011, Keyuan Petrochemicals, in what was its first year as a U.S. public company, systematically failed to disclose in its SEC filings numerous material related-party transactions between the company and its CEO and controlling shareholders, entities controlled by or affiliated with these persons, and entities controlled by Keyuan Petrochemical’s management or their family members. The related-party transactions took the form of sales of products, purchases of raw materials, loan guarantees, and short-term cash transfers for financing purposes.
In addition, the SEC alleged that Keyuan Petrochemicals also operated a secret off-balance sheet cash account to pay for cash bonuses to senior officers, travel, entertainment expenses, an apartment rental for the CEO, and cash and non-cash gifts to Chinese government officials.
Investors, who rely on transparent and relevant disclosures from the companies they invest in, may well receive the impression that the actions taken by the management of Keyuan Petrochemicals puts them at a disadvantage as shareowners. As a consequence, shareholders may develop an attitude of distrust toward the company, and this would likely not be beneficial to them or even to other shareowners.
Besides, Keyuan Petrochemicals is not an isolated case. Recognizing the importance of trust when investing in listed companies is not at all uncommon, as is also evidenced in the results of the recent CFA Institute Global Market Sentiment Survey. For example, 21% of respondents globally thought that the integrity of financial reporting was the biggest ethical issue facing global markets in 2013. So, naturally one asks what can be done to improve the status quo. In this regard, more than one-third of respondents globally emphasized improved transparency of financial reporting and other corporate disclosures, improved auditing practice and standards, and improved corporate governance practices as actions most needed in the coming year to help improve investor trust and market integrity.
In the case of Chinese companies listed on stock exchanges abroad, improvements in regulatory enforcement may not be so far away anymore, and in the process, fewer suspect business practices should be expected. According to an article in Accounting Today, the Public Company Accounting Oversight Board (PCAOB) has reached a tentative agreement for U.S. authorities to begin observing Chinese regulatory authorities during inspections of auditing firms in China as a kind of “trust-building exercise.” Not yet a perfect solution, but at least a step closer to it.
Photo credit: ©iStockphoto.com/qingwa
2 thoughts on “U.S. SEC Tough on Asian Disclosure, Accounting Abuses as Investment Professionals Demand Progress”
I agree with the author’s concern about weak disclosures in a number of Asian companies. In some cases this may be unintentional because there is a poor understanding of overseas stock exchange disclosure requirements, but in other cases this may be a deliberate attempt to cover up an egregious scheme. Whilst both are concerning, it is the latter that shareholders need to worry about the most, because these have the greatest value effect and there is a motivation to hide the issue.
Proving related party transactions with family members or existing officers of the company may be fairly straight forward for those auditors that actually exercise professional skepticism and decide to dig a little deeper. However, this may be harder if the transactions are with related parties that are built on years of personal business relationships, the transaction agreements are unwritten, or third party identities are shielded by nominee holding companies that are set up in offshore jurisdictions with strong bank secrecy laws. The problem then becomes what may define a “related” party in an Asian cultural sense, and how that relationship can be discovered in the first place.
Many Asian businesses operate within networks based on trust and personal relationships, which is perfectly legal and can have many benefits; it is a very good way of doing things. However there is the risk of value being tunneled out of the listed company to undisclosed related parties within this network, or deals being made where there is no economic substance. Sino Forest represents a good example of this. For US listed Chinese companies, this risk is exacerbated by weak internal controls, obfuscation, and uncertainty about the audit quality due to a regulatory gap where (for different reasons) neither the PCAOB nor the CSRC inspect the audit papers.
There is no easy way to solve this issue if there is too much reliance on company disclosures or the regulators and auditors sorting it out. Another safety net is needed, and this should be investors themselves looking for red flags that indicate poor disclosure of transactions resulting in the value of a company being either artificially propped or tunneled out. An ability to sort out the good from the bad may raise confidence in well behaved companies, with the reward being a higher share price. These red flags do exist, and when assessing Asian companies, I look for a number of them in the financial statements and notes to the accounts.
I have spent a lot of time investigating red flags for this purpose, using my many years of experience as an equity analyst and when I was a researcher in to Chinese accounting fraud at the Chinese University of Hong Kong. I am happy to exchange ideas with the author and other interested professionals. I can be found on LinkedIn.
Thanks for your comments.